Bank cuts rates to historic low

The shock and awe from Threadneedle Street continues. Today's further, radical 1 percentage point cut in official interest rates to just 2 per cent was laden with historical echoes. The last time rates were cut to 2 per cent from a higher level was in 1939, a month after the outbreak of the Second World War.

The historical parallel is a resonant one. Just as Britain in 1939 was braced for a long period of adversity, so, now, the country also confronts an economic Blitz. And just as, in 1940, Winston Churchill could offer a fearful nation nothing but "blood, toil, tears and sweat", so now the prospects for the coming year or more are little brighter. Britain faces a grave economic crisis, and a recession that threatens to be sharper and longer than those facing at least some of its leading rivals.

Against this backdrop, the only thing wrong with today's drastic action by the Bank of England was that it was still not enough. Having stunned the City last month with a 1.5 point cut in rates, today the Monetary Policy Committee opted for a slightly more cautious move. While this is understandable, and the Bank can no longer be accused on the excessive timidity and failure to grasp the gravity of the crisis that characterised its earlier actions in this emergency, this is no time for caution. Rates need to come down, and they need to come down as far and as fast as they possibly can. Cutting official rates to a historical low is welcome, but they now need to drop to unprecedented levels, and soon.

Even the Bank concedes in its statement today that "the downturn has gathered pace" and that there is a "weaker outlook for activity in the near-term". Remember that, in its last quarterly Inflation Report, delivered only last month, the Bank was already forecasting that the economy would plummet next year, with GDP dropping by 1.3 per cent on its central view. Now it thinks that matters are still worse. That is a scary, but probably accurate prognosis.

At the core of the looming dangers for British prospects lie the banks, and their continued failure to play their proper role in the economy, and provide a steady flow of lending to businesses and to households. While the banks' behaviour in trying to safeguard their own financial strength as the recession tightens its grip is individually rational, it is collective madness. It will mean a deeper, more painful recession - and that will mean yet bigger losses for the banks on bad loans and defaults, and fewer profitable lending opportunities when recovery, eventually, comes.

While today's cut in interest rates, and more cuts soon to come, will help, and are necessary, they are far from sufficient. For now, as Philip Shaw, of Investec, observes, what matters is not the price of money but the quantity of it that is available. "In other words, there is no point in having very cheap money if no-one will lend it to you."

That is where the problem lies at present. Indeed the Bank itself acknowledges this and hints at still more radical action, beyond cuts in interest rates, to tackle this predicament. "The MPC noted that it was unlikely that the normal volume of lending would be restored without further measures," it observes. Exactly.

The Bank and the Treasury now need to take immediate and effective steps to ensure that lending is restored. Part of that will mean further political arm-twisting by the Prime Minister, the Chancellor and their officials. But the Bank may also need to help the lenders with further measures in the money markets. Mr Shaw suggests, for example, that it could participate in the interbank markets for borrowing between the lending institutions. Still more, and bigger, injections of capital into the banks may yet be required, as both Mervyn King, the Bank's Governor, and the Government, have made clear. Beyond that, as the Bank and the Treasury have also threatened, wholesale nationalisation of the banks may also, ultimately, have to be considered if they will not deliver the lending that the economy needs - increasingly desperately.

In the meantime, rates will go yet lower, and are likely to drop to a new low of 1 per cent earlier in the new year. There are important technical obstacles to pushing rates towards zero, but that is the direction in which we are headed. Today's move was the last before the Bank enters truly uncharted territory. But it needs to do so, soon.

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